Why China’s Bank Earnings Could Surprise Investors

Bank of China, the country's fourth-largest lender by market value, defied expectations and beat consensus estimates for its third-quarter earnings on Thursday amid concerns that the sector is hurting from a slowing economy. Now, some analysts say pessimism about the sector may be overblown and that the lender's numbers may be a sign of things to come for its peers.

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The company reported third-quarter net profit of 34.76 billion yuan ($5.57 billion), higher than analysts' estimates of 32.7 billion yuan ($5.24 billion). Profits were up 16.7 percent in the July to September period, from 29.8 billion yuan a year earlier, its biggest quarterly profit gain in a year.

Interest margins also widened, with little indication demand for credit has slowed. Indeed, interest margins, which measure loan profitability, actually widened to 2.12 percent at the end of September from 2.1 percent at the end of June.

Some observers had been concerned about the sector, especially a decline in interest margins and a spike in non-performing loans, as they expected a general slowdown in the economy would have dampened appetite for loans and reduced companies' ability to finance borrowings. (Read more: China's Steel Traders Expose Banks' Bad Debts)

According to Grace Wu, Hong Kong and China banks analyst at Daiwa Capital Markets, Bank of China's margins on Thursday proved that some views had been too bearish.

"We believe the third-quarter numbers at other big banks are likely to show even better-than-expected (net margin) trends, given that Bank of China's domestic interest margins (are) already the weakest of the Big 4 banks. We believe consensus estimates …are overly bearish."

Attention has now shifted to Agricultural Bank of China (AgBank) and China Construction Bank (CCB), which will report their third-quarter numbers on Friday, and Industrial and Commercial Bank of China (ICBC), on October 30.

How Other Banks May Do

AgBank could post profit growth of 15 percent, and CCB, of about 10 percent for the quarter from a year earlier, according to Barclays' analyst May Yan. ICBC could post earnings growth of 11 percent and is the British bank's top pick among its peers, she added. Sanford C. Bernstein's senior analyst Mike Werner has estimated earnings growth of 8.9 percent, 10.4 percent and 12.2 percent for Agbank, CCB and ICBC, respectively.

While still nothing to be scoffed at, the estimates are still lower than the average of 12.45 percent earnings growth that the Big Four posted for the second quarter and marks a sharp slowdown from the 30-35 percent earnings growth enjoyed by the banks in 2010 and the first half of 2011.

However, these low expectations may mean that there could be potential for Agbank and CCB to surprise on the upside, Werner said.

"It's not going to be as bad as some people think. Interest margins are going to hold up … and businesses are still healthy," Werner said. "It's still healthy numbers coming out from these banks."

Werner is however worried about AgBank, which may not have set aside enough capital to compensate for the risk it is taking on its loan books.

"We are concerned that its low core capital adequacy ratio may force it into a dilutive equity rights offering in the coming 12 months," Werner said. "That is very negative for share prices. And that's the concern we have for AgBank now. We could see Ag bank in theory slow down their growth tremendously."

Adding to a brighter picture for Chinese banks is the non-performing loan ratio at Bank of China, which actually declined. At the end of September, the bank's non-performing loan ratio stood at 0.93 percent, down from 0.94 percent at the end of June. (Read more: China Banks' Bad Loans Steady, Capital Adequacy Up)

Simon Ho, head of regional financials at Citi, said there could be a chance that non-performing loans would increase in the third quarter for banks, but this is not in "blowup territory yet." As a comparison, the non-performing loans ratio for U.S. banks is close to 5 percent, according to data from the World Bank.

"We view both institutions as defensive plays, based on what we see as their superior financial profiles and an attractive dividend," he said. He expects the two banks to post 12 percent and 11.2 percent increase in third-quarter profits.